Sunday, November 19, 2017

Be Thankful for Risk - Weekly Blog # 498


In the northern Hemisphere, this is the season of festivals to celebrate the gathering of a good harvest. In the US, we recognize this tradition as Thanksgiving. World Stock Markets have been quite kind to investors so far this year as seen through the eyes of mutual fund holders using category averages and highlighting some exceptional performance:

US Diversified Equity Funds
+14.34 %
Sector Funds.                           
+9.76 %
World Equity Funds                 
+16.73 %
Mixed Assets Funds.               
+11.25 %
Domestic Long Term Debt         
+3.51 %
World Equity Funds                    
+7.65 %
LeaderGlobal: Science&Tech
+46.84 %
LeaderPacific: Ex Japan
+38.22 %

Source: Lipper Inc., a Thomson Reuters Company.

If the calendar year ended last Thursday night these results would be above average on a historical basis but shows that investing in Asia and in global science & technology issues has produced extraordinary results.

Performance Always Comes With Risks

Investment history is a tale of gains and loses with hopefully some lessons that can be used in the current time frame. This last week we had an example of very long-term rewards from investing in the auction of Leonardo da Vinci’s painting of Salvator Mundi for $450 million. In the Wall Street Journal, our friend and columnist, Jason Zweig made a good attempt to quantify the painting’s return, from presumably its first sale to this week. By his calculations after an attempt to adjust for inflation using gold as a very rough measure, the annual return since the sixteenth century was an outstanding 1.35%. But even this, by today’s standard low return, was better than cash, gold, and bonds, but not stocks. Another author has calculated the gain after inflation in the equivalent of the S&P500 since 1871 to be 6.9%.

There are two important lessons from this data: 

  • First, accepting risk can produce better returns than perceived safer investments. 

  • The second that the $450 million price compared to an auction house estimate of $100 million did not appropriately consider that this may be one of only 20 finished works by  the talented artist. Scarcity has a value

This is one of the reasons we favor individual stock selection over sector bets. This has implications for our fund selection process of favoring funds with less than 100 positions and even a few under twenty positions over broad index funds or passive sector funds. To us differences do  matter.

Recently we have been reviewing reports on the 13F filings of a number of well-known investment managers. In an over generalization most seem not to have owned a lot of winners in the third quarter, but continue to own and enjoy good results from positions bought years ago. +

+Email me at  for more info on our Timespan L Portfolios®

Whether we like it or not we are all risk takers anytime we get out of bed or cross a street, let alone make a long-term investment decision. In an over-simplified model any portfolio’s strategy can be summed up as capital preservation or capital appreciation or for most, a ratio of the two. In the above model of comparative returns to the value of Salvator Mundi’s portrait, it is important to note the better performance of the painting over cash, gold, and bonds. To me there is a quotient of risk in all three of the under-performers that has been viewed as “safe.” For example, cash is not protected against inflation, particularly the virulent type that has been seen periodically through history. In addition while most of the time the costs of holding cash on account is small, and with minor custodian risks, both have been known to create anxiety for cash owners. Perhaps the biggest risk in holding cash is a dramatic change in the needed use of the cash to meet needs. If these are true for cash, similar risks may be present in other “safe assets.”

At this time holding US Treasuries could be more risky than generally perceived - based on two bits of news not generally appreciated. The first is analysis by Merrill Lynch echoed by others, that Treasuries are the most crowded trade in the market. This suggests that there is a supply/demand imbalance with some of the participants not exercising price discipline which may explain why the yields on US treasuries are higher than agencies UK, German, and Japanese issues of similar maturity and perceived quality.

The second and perhaps related bit of news is an article headlined from the Financial Times which said “US Treasury dealers accused of collusion.” There are similar, other cases pending. The results of these cases one way or an another could cause disruption to not only the market for US Treasuries, but also to many markets that use treasury prices as benchmarks in setting the prices for other instruments and markets.

Accepting Intelligent Risks Can have Its Rewards

Obviously not every single risk works out for long-term investors, but many do.  The key, particularly for our longer term investment accounts is in careful selection of mutual funds. Two of the matrices that we study are prices and related valuations plus the underlying selectivity as evidenced in the portfolios of mutual funds. Currently we appear to be in a two-tier market with a couple handful of good performers becoming price performance leaders. This not true for a second tier.

One study points out unlike in 2000 the fifty largest companies in the S&P500 were selling at 31 times earnings. Today the fifty largest is selling at 17.9% which is generally in line with historic records. One explanation for the high valuations of some stocks is the Charlie Munger belief adopted by Warren Buffet that it is better to “buy a wonderful company at a fair price than a fair company at a wonderful price.” This philosophy depends on the ability to find wonderful companies at fair prices. In my mind, this is dependent on sound and smart investment analysis. A good investment analysis course could be taught exclusively on the wins and losses in Berkshire Hathaway’s* history. Recently they have been reducing a large position in IBM which perhaps has not yet developed into a wonderful company and have been buying Apple*, still evolving as a wonderful company. While Berkshire is a very long-term investor in a number of securities, it is price sensitive, currently sitting on $110 Billion in cash and $180 Billion in investments.
*Held either personally or in the private financial services fund I manage.


Accepting the risks of disappointing results from time to time does not diminish the odds in favor of long-term gains. One needs to balance the goals of capital preservation and capital appreciation. The ratio should
probably shift inverse to near-term market performance.

Question of the Week:

If you were forced in terms of your own account how would you divide your portfolio into only two buckets between capital preservation and capital appreciation and is the mix different in your professionally managed accounts?

Sunday, November 12, 2017

On To Stock Peak; Mild Danger - Weekly Blog # 497


Gift buying is strong selectively in US and China this week. While political leaders emote, speculations in stocks are increasing and fixed income vehicles are displaying fault lines. Current concerns produce hurdles, not walls that can’t be breached. One of the benefits of segmenting portfolios into sub portfolios based on time horizons is to be able to focus on the impacts of various influences. This is the rationale for developing the TIMESPAN L Portfolios® and how we look at the current picture.

Next Two Years

While most investors swear allegiance to being long-term investors, almost all that they consume in the way of views is what to do right now and that will be judged on the basis of the next month, quarter, current year and next year. They over emphasize whatever near-term payment concerns they have and ignore the impacts on longer term needs. If that is the tune that investors are currently dancing to, I will display what I believe to be relevant to this period’s dance.

In a consumer driven economy one should look at shoppers. At the local high end mall Saturday night it was crowded with people carrying a small number of shopping bags. We got the sense beyond buying, that  shoppers were examining prices, styles, quality, and inventory. At the crowded Apple* store there were lines of buyers that began in the morning and were still present in the evening. What is on sale for shoppers are items that they could buy either at many stores, or they came to buy in one particular store, online or both - but they came to spend money. There were so many of them at three of the restaurants within the mall that the wait for tables stretched to an hour or beyond. 

In China the wonderfully manufactured Singles Day apparently once again produced record orders for merchandise and services. The purchases broadened out from buying for someone special to the buyer to the buyer herself or himself.

These controlled shopping frenzies were also present in the stock and bond markets. In the US, S&P* has developed a quality ranking array which is different from its credit ratings. In the credit ranking array the objective is to gauge the odds on timely payment of future payments of principal and interest. Balance sheets and their future projections drive the credit ratings. On the other hand, the quality rankings are based on the income statements and the ability to grow them. In the last month particularly (and also for the latest twelve months) the companies with the low to lowest quality rankings had the stocks that appreciated the most. Obviously these stocks were perceived to have prices that deeply discounted their futures.
* I personally own shares in these stocks

Individual stock investors as measured by surveys of the American Association of Individual Investors (AAII) have a similar view as to the shoppers. In the last two weeks the percentage of those surveyed has dropped their bearish views from 33% to 23%. While this is a very volatile time series on the basis of casual conversations, it seems to be reflective of current thinking.

Equity Fund Leaders

In the week that ended Thursday, the weekly 14 of the top performing 25 performance leaders for the week were the Natural Resource and Energy Commodity funds. Six out of 10 losers for the week were with bank-heavy financial services funds. 

The enforced hotel “guests” in Saudi Arabia are probably a stimuli for the leaders. UBS points out that 70% of the world’s growth in GNP this year was caused by rising commodity prices both in energy and industrial metals. The decline in bank oriented funds could be an over-reaction from a view that materially lower US corporate taxes will be delayed and may be smaller than expected. On both the up and down sides of the week one can see the influence of news/rumor on near-term prices. I maintain the long-term trend of future energy prices were not changed by the Saudi arrests nor have the tax rates for banks changed the long-term generation of earnings and dividends of banks beyond perhaps a one time bump in 2018 or 2019. 

Fixed Income Markets Display Longer Term Concerns

Most often stock market declines are preceded by weakening fixed income markets. We are seeing some concerns being expressed in fixed income prices/yields. High Yield bond prices fell this week. Normally these, in effect, stocks with coupons which is what one wag called junk bonds, fall with the increase in the expected default rate or an actual unexpected default. Moody’s** who typically has the best, but not a perfect record on expected defaults, is now expecting the stock market to rise because of low and declining expected default rates.
** Owned in a private financial services fund that I manage.

The fall in junk bond prices could be a reaction to the discussed restrictions on the tax deductability of interest charges to 70% of EBITDA, Earnings before interest, depreciation, and amortization.  A large amount of refinancing is expected over the next two years -  particularly by the mid to smaller energy companies that could be placed in jeopardy and possibly bring on defaults. 

Each week I look at the fixed income fund performance data from my old firm, now a part of Thomson Reuters. I have noticed for some time that US Treasury funds have consistently done better than US Government funds that often pay more interest than Treasuries. This has been true for at least five years for longer maturity funds and at least three years for the shorter ones. This must indicate that for some reason Treasuries are more valuable than higher earning agencies. I suggest one reason for this is that US Treasuries are being used as collateral for loans where agency paper is not as readily acceptable. Further I suspect that this collateral is backing loans for dealer and hedge fund securities which include positions in Exchange Traded Funds and Exchange Traded Portfolios. It is significant to point out as to the level of speculation in these markets that Deborah Fuhr  of ETFGI reports that globally this year, listed  funds that leverage have seen their assets grow 14% to $77 billion.

One of my market structure concerns is that financing inventory positions for market makers, authorized participants, hedge funds and brokerage firms is normally done with call-loans. A call-loan can be called with very little, if any, notice. Often when the loans are called the only way to pay it off is to sell some of the easily traded holdings. These are not price sensitive sales but are persistent. As in the past this can be a cause of an internal market panic. I do not rule out a recurrence of such an activity.

Endowment Period Concern

The focus has been first on low productivity of human labor. Next it has turned to capital productivity which is being addressed increasingly by additional leverage. I am now becoming more aware of research and development productivity. In each of the three productivity challenges part of the answer is better selectivity of people, projects, and research targets. All of these are being addressed, but with limited near term success.

Part of the problem is that there are shortages of attractive alternatives. Hiring more, poorly prepared laborers; committing more financial resources to low return ventures; not achieving technological breakthroughs in research; and utilizing the wrong scale for development won’t solve the problem. We need to both make smarter decisions and examine the structural impediments holding back productivity including education, appropriate returns for risk capital, and avoiding unwise intellectual property constraints. Some progress is likely in the very long-term. I just hope it arrives quickly enough to meet the retirement needs for today’s workers and students.

Misallocation of Capital

One of the advantages of focusing on Mutual Funds and ETFs is while they are large contributors of capital to our global society, they are also part of the institutional and individual mind set. For the latest twelve months looking at positive net flows of money coming into mutual funds with aggregate flows into investment categories, there are six each bringing in over $20 Billion. Five out of the six were bond funds which may do relatively little to address the productivity issues raised above. The more additive value to longer term corporate investment are equity funds. Unfortunately in spite of very good investment performance recently they are in heavy net redemptions with Large Cap Growth funds shedding $76 Billion and Large Cap Value funds $49 Billion. These net redemptions are almost actuarial in that they were purchased years ago to meet future needs which are now apparent. In the past redemptions were met by new sales. Currently it is more profitable for the financial community to redirect flows to other products. While some at the retail level is being directed into ETFs the bulk of their flows are from trading establishments that have short-term holding periods and rarely buy new IPOs. Nevertheless ETFs on many days have more net flows than the much larger mutual funds. Over the same twelve months previously mentioned, there were six ETF categories that generated over $20 Billion each. Five went into equities and one into bonds. Their flows are not likely to provide the long term risk capital that is needed for increased productivity of labor, capital and R&D.
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A. Michael Lipper, CFA
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Sunday, November 5, 2017

Different Forts: Misconceptions on Risk-less Investing +
3 Reasons for Equity Mutual Fund Redemptions - Weekly Blog # 497


Attorneys in court often arrange “the facts” to support a conclusion. Economists and Professors of Finance suffer from “physics envy” of immutable laws. Politicians and pundits speak in sound bites. Investors, like other good judges, look at all of the information found in hard and soft data. Most importantly, investors should avoid accepting any proposition on the face of what is presented. Wise investors have learned to probe for a more complete understanding of what is on offer. 

Is Risk a Number?

Pity the poor professor introducing investments to a class. He or she finds it easy to introduce the concept of gains. It is essentially one of addition or in some cases multiplication. The problem is to introduce the concept of losing which is similar to subtraction. The real issue is to come up with a way to measure potential rewards vs. potential losses to get to a conclusion as to the risk of an investment. In the search for a mathematical answer rather than a deeper understanding of the different kinds of risks facing different investors, academia came up with the movements of US Treasury bond prices.  They measure the price pattern of the desired investment versus the volatility of Treasury prices. Thus, the idea of a “risk-less” rate of return was born. Investment sales forces deducted this so-called risk-less rate from the actual performance of a stock (and more frequently a fund or other portfolio) to create a comparison of favored investments, adjusting for risk.

While it is true that often the movement of treasury prices captures a reasonable amount of the general volatility in the stock market, for investors risk is the penalty for being wrong that causes changes in spending plans. It is these risks that cause pain to investors and their beneficiaries plus create “career risk” for hired professionals.

The use of Treasury prices presumes that there is no fundamental changes in the future of the Treasury market. Because of the changing market structure I believe that there will be periodic changes in the Treasury markets. In this weekend’s Financial Times John Authers has a column that is headed “Liquidity looms as the real challenge facing new Fed Chair Powell.” While he doesn’t spell out the problem, it is clear in the future he is properly worried that the various central banks led by the Federal Reserve will be cutting off credit through the banks to the fixed income market. While the Dodd Frank Act curtailed the commercial banks and large investment banks in their market-making efforts in securities, it did not really address the banks’ extension of credit to the few remaining market-makers. These credits are much larger than the banks’ own securities positions. There is already a shortage of repurchase agreements or repos at present. One sign of structural disequilibrium is that for ten year Government bonds, the US is paying 100 basis points more than the UK pays for its bonds and 200 basis points more than the German bonds. This suggests that the US paper is worth more. Why? I believe the reason is that it is the best collateral for loans that support borrowings for the purchase of derivatives and currencies which can be extremely volatile. Since most loans are immediately callable, there is the sort of risk that started the problems that led to the 1987 and Lehman crises.
Thus the ownership of a 4% yielding common stock or fund with a payout ratio of 40% or less and a price/earnings growth rate in the single digits versus a holding in US treasuries may be more dangerous in terms of risk to the investor and career risk to the professional. But these are unconventional thoughts.

Investors Rejecting Equity Mutual Funds

The constant drumbeat that retail investors are deserting mutual funds in favor of ETFs needs much deeper analysis than the pundits are giving it. For a number of months industry headlines have been screaming about the net redemptions of equity funds and this week is no different. Except they are missing the motivation behind the redemptions and its significance. The largest amount of redemptions is coming out of the Large Cap Growth funds. I do not believe that it is performance-related. On a year to date basis through November 2nd,  my former firm, Lipper Inc., reports that Large Cap Growth funds, on average, have gained 26.03%.  No other non-leveraged, General Equity fund category has done as well this year or even in the last five years. The only other domestic funds that have done better are the Science & Tech funds. Some International funds have done better in part due to foreign exchange considerations.

Why are there so many redemptions?  There are three answers. The first is simple, the second is structural and the third has to do with the changes in the brokerage market.

The simple answer is that the Large Cap Growth funds have more assets than any other investment objective. Thus, logically over time it will have more redemptions. 

The structural answer is that investors put money into funds to meet future needs. The very day that someone invests in a fund, a future redemption is set up in the indefinite future. Because of the way many estates are settled, usually liquid investments are sold to distribute as much cash as quickly as possible so funds are not often directly inherited.

The third cause of redemptions relates to the fact that a large portion of investors in mutual funds was sold by commissioned-paid brokers. At the time of many of these transactions the commissions of mutual fund sales were among the highest rewards to the sales force. Currently many of these salespeople have morphed either into registered investment advisors or have changed firms for understandable reasons. In their new shops they are no longer motivated by commission sales but by investment advisory fees. As their books of business mature, there is little attempt to replace stock mutual funds in their aging accounts. These investors are converting their investments into either fixed income funds (whose sales are booming in spite of the likelihood of higher interest rates/lower bond prices), or into Exchange Traded Funds. In the latter case the investment adviser will charge an annual fee that within a few years will more than compensate for the loss of mutual funds sales commissions.

Hints For the Future

At some point before the current market suffers a major decline, there will be a more general recognition as to the risks in the fixed income market with higher yields driving fixed income prices down. The credit cycle in high quality paper will contract. It is likely that we may be surprised by the levels of domestic and international bankruptcies which won’t be isolated events.

On the equity side grudgingly we are seeing enthusiasm growing. In the last two weeks sentiment has become more bullish as measured by the American Association of Individual Investors (AAII). It will have to be sustained for a considerable period of time to fulfill a bear market indicator. In addition to Large Cap Growth funds and stocks doing well, industrial metals commodity prices are also ahead, showing a year to date gain of 25.11%. One of my senior analyst friends describes his current portfolio as a 1950s one. As many of the relatively newly minted investment advisors don’t have the historic perspective for the type of market we appear to be entering, they will disappoint some of their customers leading to a positive surge in equity mutual fund sales. (As an owner of a number of domestic and international mutual fund management company stocks both in my private financial services fund and personally, I hope so.)

Question of the Week:

For your own account how are you defining risk?  
Did you miss my blog last week?  Click here to read.

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Copyright ©  2008 - 2017

A. Michael Lipper, CFA
All rights reserved
Contact author for limited redistribution permission.